Accounting Standards Setting: Inconsistencies in Existing GAAP

By Forsyth, Timothy B.; Witmer, Philip R. et al. | The CPA Journal, May 2005 | Go to article overview

Accounting Standards Setting: Inconsistencies in Existing GAAP


Forsyth, Timothy B., Witmer, Philip R., Dugan, Michael T., The CPA Journal


In October 2002, the Financial Accounting Standards Board (FASB) issued a proposal to adopt a principlesbased approach to setting accounting standards. FASB's proposal is a reaction to the complexity of the "rules-based" or "cookbook" approach to setting accounting standards. For example, Harvey Pitt, then sec chairman, testified before the U.S. Senate Committee on Banking, Housing and Urban Affairs about the need for principles-based accounting standards:

Much of FASB's recent guidance has become rule-driven and complex. The areas of derivatives and securitizations are examples. This emphasis on detailed rules instead of broad principles has contributed to delays in issuing timely guidance. Additionally, because the standards are developed based on rules, and not broad principles, they are insufficiently flexible to accommodate future developments in the marketplace. This has resulted in accounting for unanticipated transactions that is less transparent and less consistent with the basic underlying principles that should apply [March 21,2002].

FASB's proposal indicates that it accepts this criticism as at least partially valid. Indeed, FASB explains that the level of detail in recent standards is partly attributable to political compromises made in order to gain acceptance of a standard. The compromises include providing for scope exceptions (exempting from the standard some otherwise covered transactions), exceptions that limit volatility of reported earnings, and exceptions to mitigate transition effects to a new standard. Katherine Schipper ("Principles-Based Accounting Standards," Accounting Horizons, March 2003) argues that FASB generally follows a principles-based approach, but the exceptions and interpretive and implementation guidance provided by FASB may make recent standards appear to be rules-based.

In 2003, the SEC published a staff report in which the concept of principles-based standards was clarified. According to the report, principles-based standards "should have the following characteristics:

* "Be based on an improved and consistently applied conceptual framework;

* "Clearly state the accounting objective of the standard;

* "Provide sufficient detail and structure so that the standard can be operationalized and applied on a consistent basis;

* "Minimize exceptions from the standard;

* "Avoid use of percentage tests ('brightlines') that allow financial engineers to achieve technical compliance with the standard while evading the intent of the standard."

Even if FASB's approach is generally principles-based, as defined by the SEC, a large portion of current GAAP is based on standards adopted before the completion of the conceptual framework project or promulgated by FASB's predecessors, the Committee on Accounting Procedure (CAP) and the Accounting Principles Board (APB). Both the CAP and the APB were heavily criticized for their "piecemeal" approach to setting standards, which resulted in standards that were not consistent with each other or with an underlying set of accounting principles (Stephen A. Zeff, "Some Junctures in the Evolution of the Process of Establishing Accounting Principles in the U.S.A.: 1917-1972," Accounting Review, July 1994). Some inconsistencies in GAAP are related to basic recognition criteria for assets and liabilities (e.g., noncancelable purchase agreements versus capital leases). Other inconsistencies exist because of differences in measurement criteria (e.g., discounted cash flows in the case of non-interest-bearing notes versus undiscounted cash flows in the case of deferred taxes).

Some areas of existing GAAP seem inconsistent with the first characteristic of principles-based standards, that they be based on an "improved and consistently applied conceptual framework." Specifically, these inconsistencies are apparent in three areas: 1) executory contracts, 2) valuation of future cash flows, and 3) stock dividends and stock splits. …

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